For nearly a year inflation has been a spectre haunting the global economy. The question is: how afraid should institutional investors be? The initial view identified inflation as being transitory. Once the global economy started moving again, when the worst of Covid appeared to be behind us, and logjams in various supply chains start to clear, the outlook would be rosy and inflation would diminish as a threat.
This could well be true. Although things have not turned out like that as inflation has kept rising. By the end of 2021, the consumer price index inflation rate hit 5.1% – a rate the Bank of England expected it to reach by the spring of this year. In its November Monetary Policy Report, the Bank stuck to its transitory inflationary outlook: “We expect these high rates of inflation to be temporary.”
This view was endorsed by the December report. “Bank staff expect inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022, with that further increase accounted for predominantly by the lagged impact on utility bills of developments in wholesale gas prices,” the report stated.
This view is not shared universally. Jari Stehn, chief European economist at Goldman Sachs, says inflation will peak at 7% in the UK during April. That said, he does think it will slow from that point onwards.
The inflationary picture has many nervous commentators asking: how long is a transitory phase before it becomes baked in as an actual trend? Many economists have been arguing over, and redefining, the true meaning of transitory.
What is clear is the picture thus far has had a financial cost. According to consultant Lane Clark & Peacock, inflation has already weakened UK corporate balance sheets by around £20bn due to the impact on pension scheme valuations – and this could turn much worse if it becomes more than a transitory blip.
How much of an inflationary abyss are we staring into in 2022? Much centres on the transitory analysis. If you accept that the inflation rate is transitory, then it could be a case of jog on, nothing to see here. Richard Williams, chief investment officer at Railpen, says: “Of course, it depends on how one defines ‘transitory’. But from Easter 2022, it’s likely that annual inflation rates will fall from their current levels, and perhaps markedly.”
On this scenario inflation could be on the turn. “Headline inflation rates are probably at their peak,” Williams says. “Yes, there’s a plausible scenario that resembles the 1970s, but it is more likely that inflation rates will fall. However, I expect most of them to eventually settle in a range above those that existed pre-Covid. And perhaps the subsequent volatility of inflation will be greater.”
Chris Jeffery, head of inflation and rates at Legal & General Investment Management, says there is a yes and no case for stating that inflation is transitory. “Some of the biggest drivers of inflation are evidently transitory: the squeeze in the used car market and the spike in natural gas prices are the most obvious examples. But a series of cascading transitory shocks means that inflation has been high enough for long enough to impact wage-setting behaviour. The problem with the ‘transitory’ versus ‘persistent’ debate is that, in this case, one leads to the other.”
There are factors pointing to a transitory scenario, says Catherine Doyle, investment strategist in the real return team at Newton Investment Management. “Supply issues will undoubtedly continue to have some impact in 2022, albeit with pressures moderating. The steep rise in energy prices has also been a feature in recent months. On this front there will likely be a mechanical improvement as the sharpest rises will drop out of the annual calculations in the second quarter of next year.”
On this basis, Doyle notes there is a likelihood that inflation has peaked and will come down gradually. “Although, it is likely to settle at a higher level than in previous years. As the Covid recovery evolves, demand is likely to shift from goods to services, and in so doing, may drive more inflation on this side of the economy, which offsets some of the likely easing of pres- sure on the goods side,” she says.
This means the re-opening of the service side of the economy has implications for wage inflation, which has also picked up of late.
“While this will likely moderate in the medium-term, in the immediate future labour looks set to have a stronger bargaining position. Furthermore, and especially in the US, rents, which form a not insignificant part of the inflation basket, are anticipated to see further upward momentum,” Doyle says.
Leaving its mark
There is an outlook that states inflation is neither as problematic as suggested nor likely to be a simple reversion back to normality, after a blip of a transitory phase. Instead, the current inflationary situation could well to leave its mark.
“The extreme extent of inflation is probably transitory, but we have also turned the corner on permanently low inflation,” says Stuart Trow, who has just retired as a credit strategist at the European Bank for Reconstruction and Development.
If it is going to leave its mark, what can be cited as the biggest concern regarding inflation? “In the West it is what rising yields will do to asset prices and in emerging markets what rising food and fuel cost will do to political and social stability. “In fact, many western nations will struggle politically with higher living costs, especially if they add austerity on top,” Trow says.
Doyle points to other issues that could fuel inflation. “Other factors that may prove more enduring in terms of their contribution to inflation are the likely peaking of globalisation, the greater role being played by fiscal stimulus in a post Covid world – as opposed to the dependence upon monetary policy over the last decade – and also the related matter of decarbonisation. While this latter development will ultimately pave the way for cheaper renewable sources of energy, in the short-term the transition will potentially have an inflationary impetus,” she says.
As bad as it gets
This raises a big question about how bad the inflationary picture could get – even within a transitory scenario. “The exact level will depend on how the pandemic unfolds, but I can imagine that towards the end of next year we might be talking about supply gluts rather than shortages as demand eases and some of the logistical issues are addressed,” Trow says.
Giving his outlook, Jeffery says: “We see US core – excluding food and energy – inflation peaking at 6% in the spring before falling back again as some of the one-off re-opening effects wash out of the annual comparison.
“In the UK, we see a lower peak with headline inflation on a CPI basis peaking around 5%,” he adds. “At the best of times, inflation forecasts are a hostage to the fortunes of commodity markets. Given the wild swings in natural gas prices in recent months, and the uncertainty about whether the government will intervene, that is especially true today. Anybody’s inflation forecasts should be taken with a truckload of salt.”
Jeffrey also notes that when it comes to the UK’s inflationary picture, it is important to monitor the labour market. “Most notably, the loss of jobs among the self-employed and part-time workers. As those people get drawn back into work, we expect to see further upward pressure on wage growth.”
At the global level, there is a need to monitor the Covid situation in China carefully, he adds. “The struggles to maintain a zero-Covid strategy in the face of the highly contagious Omicron variant pose a serious risk to global supply chains that could see another round of price pressures in the global goods markets.”
I fear that we will again fall into the trap of believing that inflation is a problem that can be addressed by monetary policy alone.
Stuart Trow, formerly the European Bank for Reconstruction and Development
Behind the inflationary curtain
Understanding where this inflation came from, aside from the Covid pandemic, is important in understanding the wider infla- tionary picture, says Trow. “It is important to be clear about why inflation had been so low for so long and had been impervious to ever more extreme monetary easing measures to boost it.
“It was the supply side shock of globalisation – rather than monetary policy – that kept a lid on wages and the prices of consumer goods,” Trow adds. “Western workers couldn’t compete, which is why real median wages have either flatlined or trended lower over much of the past 20 to 30 years.”
On this scenario, even before the pandemic, however, the trade war with China, amongst other things, first slowed then reversed global trade growth.
“That was one of the reasons Germany was almost in recession even before the pandemic began,” Trow says. “The reversal – or even just slowing – of trade growth has meant that higher cost solutions to supply chain vulnerabilities have had to be found and western workers are starting to rediscover their pricing power.”
Put another way, James Brooke Turner, investment director at the Nuffield Foundation, says: “The idea is that Chinese manufacturing has changed the inflation landscape for the past 30 years, but might not continue to change it over the next 30.”
Dealing with this complex inflationary environment presents obvious challenges, but there are ways out of the maze, says Railpen’s Williams. “Given the uncertainty around inflation, interest rates and other macro variables, we look for long-term investments that should prosper largely independently of the macro environment.
“For more macro-sensitive investments we have made some alterations that could be described as conventional inflation-protection measures,” Williams says.
But given his more upbeat inflationary position, he adds: “From this juncture it’s more likely that our focus on inflation- protection will be marginally reversed rather than increased.” On a marker of how institutional investors should respond, Trow says: “The key issue is how far bond yields rise.”
“I fear that many managers have continued to buy equities for a lack of a suitable alternative since bonds were an even bigger bubble,” he adds. “If the equity rally starts to stall and suddenly US treasuries are offering 2.5% to 3%, the case for de-risking will look more attractive.”
For Jeffrey, it is taking risk out of the equation. “Our mantra remains the same: investors should hedge unrewarded risk and carefully manage rewarded risk. “In aggregate, the pension fund industry has rarely been in better shape with the industry funding ratio up by more than 10% in the past 12 months,” he adds. “That improvement looks set to trigger further conversations about additional hedging of inflation risk for those who are uncomfortably exposed.”
Doyle notes that an investment portfolio should be built to deal with the stresses and strains of inflation. “Our investment approach is dynamic and takes account of the evolution of a constantly-changing backdrop. A more inflationary backdrop is just one of the developments that inform the shape and structure of the portfolio. We have some inflation protection built into the real return portfolio through holding a significant equity allocation.”
She adds: “Many of the companies held exhibit significant pricing power, an important consideration in a more inflationary world. In addition, many of our investments in alternatives, which form part of the return-seeking core, benefit from inflation-linked contracts.”
However, Doyle adds that the most important attribute for a multi-asset investment manager will be to remain flexible, rec- ognising that the opportunity set will change as the sands shift within the market backdrop.
Although the revival of inflation concerns in the past 12 months is a reminder of the difficulties of predicating an investment portfolio on any single scenario playing out.
The idea is that Chinese manufacturing has changed the inflation landscape for the past 30 years, but might not continue to change it over the next 30.James Brooke Turner, Nuffield Foundation
“Few investors saw the 2008 crash coming, almost none saw the pandemic coming, and practically no-one was warning about inflation risks a year ago,” Jeffrey says. “‘Don’t predict, prepare’ is the message.
“The first step in preparation is to build a well-diversified portfolio, the second step is to think about the plausible risks and stress-test that portfolio accordingly,” he adds.
Moreover, until recently, equity markets have been impervious to inflation developments. “That makes sense if you think that the corporate sector is able to pass through cost increases to consumers, leaving their bottom line largely unaffected,” Jeffrey says. “There has been some significant sector rotation within equities towards value stocks. That looks set to continue as the inflation outlook heats up.”
The impact on the bond market is more direct, with upward pressure on gilt and US treasury yields, but the impact has been quite subtle: 30-year gilt yields, for example, are below the levels we saw last spring before the inflation picture changed. “Time and again, investors should have learnt that it is dangerous to assume that yields continue rising in a straight line,” Jeffrey adds.
While inflation may drive volatility in growth asset portfolios, it’s worth noting that many defined benefit schemes will have had a strong 2021 in terms of funding level progress. This afforded the opportunity to de-risk schemes, reducing sensitivity to inflation going forward: lower growth assets and higher hedge ratios.
“Investors who see inflation as the primary risk to their portfolio risk making investments in assets with poor risk-return profiles – like gold and inflationary-linked treasuries – at the expense of investments which are more leveraged to economic growth – like equities and real estate – but also provide a reasonable amount of protection against higher inflation,” an investment strategist told portfolio institutional.
Role of central banks
A big question in all this is how the Bank of England and other central banks have dealt with the situation adequately. “Record levels of peacetime debt and real interest rates of -5% don’t really reflect well on fiscal and monetary authorities,” Railpen’s Williams says.
Central banks were arguably too generous in supplying liquidity, Dolyle says. “They had tolerance for inflation to overshoot on the upside since it had previously undershot on the down-side. They have now been compelled to act quickly to rein in liquidity which could represent a risk for markets leading to bouts of volatility,” she says.
And Jeffery asks: “Are central banks willing and able to take the actions necessary to reduce price pressure by raising interest rates and ending asset purchases? The answer to that is becoming ever clearer: yes. We have seen the first steps from the Bank of England, raising interest rates despite the economic threats of the Omicron variant.”
The next question is whether inflation is controllable without imposing more severe economic costs. “Here, we worry that investors – and central banks – have become too complacent that merely easing off the accelerator will be enough to bring inflation back down,” Jeffrey says. “In some parts of the world, notably in eastern Europe, central banks are clearly now applying the brakes. Our concern is that the Bank of England and the Fed may soon have to follow.”
An inflation trap
And some of the thinking underpinning inflationary analysis can be an issue that creates its own problems. A legacy of the Milton Friedman monetarist theory that inflation is always and everywhere a monetarist phenomenon is a problem for Trow. “I fear that we will again fall into the trap of believing that inflation is a problem that can be addressed by monetary policy alone,” he says. “Since the era of independent central banks, we’ve not really had a global example of stagflation, so rising prices and slowing growth is not something inflation targeting has been tested on.”
Given the situation, do investors therefore have any easy tips in dealing with the inflationary outlook? “There are no good answers here,” Jeffrey says. “When inflation is a problem, policy needs to constrain aggregate demand and expand aggregate supply. The first is economically and politically painful.
“The second is incredibly difficult, as evidenced by the never-ending quest to improve the UK’s productivity growth. Focused measures to ease shortages in certain sectors can help in the short-run, but unless macroeconomic balance is restored this problem won’t disappear overnight,” he adds.
Putting the whole picture into perspective by looking at things going forward over the next year, Williams says. “Inflation is topic du jour, but I suspect that something else will be the centre of attention in a year’s time – that tends to be the way in economics and markets,” he adds, ending with a caveat warning: “If inflation still is the main topic, then things could be very problematic.”